Five Core Principles for Investors

Here are five core principles every investor should keep in mind:

1. DIVERSIFICATION: Diversification is how you limit the risk of losses in an uncertain world.

If, 30 years ago, a visitor from the future had said that the Soviet Union had collapsed, Japan’s stock market had stagnated for a quarter century, China had become a superpower and North Dakota had helped turn the U.S. into a fast-growing source of crude oil, few would have believed it.

The next 30 years will surely be just as surprising and unpredictable.

Diversification among different assets can be frustrating.  It requires, at every point in time, owning some unpopular and beaten down assets.

Why would I want to own European stocks if its economy is such a mess?  Why should I buy bonds if interest rates are so low, and the prospect of them rising?

The appropriate answer is, “Because the future will play out in ways you can’t possibly comprehend.”

Owning a little bit of everything is a bet on humility, which the history of investing shows is a valuable trait.

2.  BEHAVIOR: You are your own worst enemy.

The biggest risk investors face isn’t a recession, a bear market, the Federal Reserve, or their least favorite political party.

It is their own emotions and biases, and the destructive behaviors they cause.

You can be the best stock picker in the world, capable of finding tomorrow’s winning businesses before anyone else.  But if you panic and sell during the next bear market, none of it will matter.

You can be armed with an M.B.A. and have 40 years before retirement to let your savings compound into a fortune.  But if you have a gambling mentality and you day-trade penny stocks, your outlook seems dismal.

There aren’t many iron rules of investing, but one of them is that no amount of brain power can compensate for behavioral errors.  Figure out what mistakes you are prone to make and embrace strategies that limit the risk.

3.  VOLATILITY: There is a price to pay.

The stock market has historically offered stellar long-term returns, far better than cash or bonds.

But there is a cost.  The price of admission to earn high long-term returns in stocks is a ceaseless flow of unpredictable outcomes, senseless volatility, and unexpected downturns.

If you can stick with your investments through the rough spots, you don’t actually pay this bill; it is a mental surcharge.  But it is very real.  Not everyone is willing to pay it, which is why there is opportunity for those who are.

There is an understandable desire to forecast what the market will do in the short run.  But the reason stocks offer superior long-term returns is precisely because we can’t forecast what they will do in the short run.

Someone once asked J.P. Morgan what the market will do.  “It will fluctuate,” he allegedly said. Truer words have never been spoken.

4.  COSTS: When in doubt, choose the investment with the lowest fee.

As a group, investors’ profits always will equal the overall market’s returns minus all fees and expenses.

Below-average fees, therefore, offer one of your best shots at earning above-average results.

A talented fund manager can be worth a higher fee, mind you.  But enduring outperformance is one of the most elusive investing skills.

According to Vanguard Group, which has championed low-cost investing products, more than 80% of actively managed U.S. stock funds underperformed a low-cost index fund in the 10 years through December.  It is far more common for a fund manager to charge excess fees than to deliver excess performance.

There are no promises in investing.  The best you can do is put the odds in your favor.  And the evidence is overwhelming: The lower the costs, the more the odds tip in your favor.

5.  TIME: Time is the most powerful force in investing.

Warren Buffett’s current net worth is around $85 billion, nearly all of which is in Berkshire Hathaway stock.  Berkshire’s stock has risen 24-fold since 1990.

Do the math, and some $70 billion of Mr. Buffett’s $73 billion fortune (~96%!) was accumulated around or after his 60th birthday.

Mr. Buffett is, of course, a phenomenal investor whose talents few will replicate.  But the real key to his wealth is that he has been a phenomenal investor for two-thirds of a century.

Wealth grows exponentially – a little at first, then slightly more, and then in a hurry for those who stick around the longest.

That lesson – that time, patience and endurance pay off – is something us mortals can learn from, particularly younger workers just starting to save for retirement.